Which debt should you pay off first?
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You’re not alone if you have debt on more than one credit card or loan. Americans with credit cards average $5,525 in debt, according to a 2021 Experian report. That doesn’t include additional debts, such as mortgages, car loans and student debt.
While you should always make at least the minimum monthly payment on every debt you owe, it can be hard to know how to prioritize any extra debt repayment dollars each month.
There are several strategies to start paying down debt. However, it may be wise to focus on some debts above others. Simply making small monthly payments spread across all your debt could result in you paying more interest over an extended period. Once you choose a debt repayment method, the most important thing you can do to become debt-free is to stick with it.
Option 1: Pay off the highest-interest debt first
- Key advantages: Allows you to save money and redirect funds to other financial goals.
- Key drawbacks: If your largest debt also has the highest interest rate, it could take a while to pay it down. This may discourage some people, increasing the likelihood of giving up on the strategy.
- Best for: Minimizing the amount of interest you pay.
There’s a good reason to pay off your highest interest debt first — it’s the debt costing you the most. Credit cards with higher-than-average APRs can be especially hard to pay off. Anyone with a student loan or mortgage knows the frustration of making monthly payments that only go toward the interest, not the principal.
Paying off high-interest debt first is commonly referred to as the avalanche method. Keep making the minimum monthly payments on all of your credit cards and loans, but put every extra penny you can toward the card or loan with the highest interest rate. If you need help, you can start by looking at five steps to pay down your debt as quickly as possible.
While focusing on your highest-interest debt first is a smart move, it isn’t necessarily the best option for everyone. If you’re making monthly payments on many debts, you might not have a lot of extra money to put toward your highest-interest debt. The avalanche method might also be discouraging if you have a large debt since paying it off could feel impossible.
Assume you have the following debts:
- Credit card 1: $500 balance and 20 percent APR
- Credit card 2: $1,000 balance and 21 percent APR
- Auto loan: $20,000 balance and 8 percent APR
- Personal loan: $5,000 balance and 12 percent APR
- Student loan: $12,000 balance and 7 percent APR
You’ll make the minimum payments on all your accounts, but apply any extra funds leftover for the month to credit card #2 since it has the highest interest rate. Once it’s paid off, you’ll continue the same pattern by focusing on credit card #1, followed by the personal loan. Repeat this cycle until all the balances are paid in full.
Option 2: Pay off the smallest debt first
- Key advantages: Helps build motivation and encourages you to stick with the plan.
- Key drawbacks: It may take longer to become debt-free, and you could pay more in interest.
- Best for: People who struggle to stay motivated with paying off debt.
While some people choose to address their debt based on the interest rate, others pay off their smallest debt first and work their way up to the largest one. This debt repayment method, popularized by financial expert Dave Ramsey, is called the debt snowball because it starts small and grows over time.
The snowball method works because paying off a debt in full incentivizes you to keep working toward your goal. As you pay off your smaller debts, you’ll have more money to put toward your larger debts.
You might end up paying more in interest than you would have paid if you tackled your highest-interest debt first, but the psychological benefits of getting those smaller debts paid off as quickly as possible can be very rewarding.
To get started with your debt snowball, list all of your current debts — and their current balances — from low to high. Continue to make the minimum monthly payment on all of your debts while putting as much extra money as possible toward your smallest debt. Once that debt is paid off, put your extra money toward your next-smallest debt, and so on.
Using the same figures above, start by focusing on credit card #1 since it has the lowest balance. After it’s paid off, move on to credit card #2, then the personal loan.
Option 3: Pay debts that most affect your credit score
- Key advantages: You’ll have more opportunities to qualify for lower APRs and receive increases in spending limits.
- Key drawbacks: Focusing on your credit score may also require lifestyle changes, making it easier to lose motivation.
- Best for: People looking to finance a large purchase, such as a house or a car.
Your credit score can help lenders understand how you manage your finances. It is affected by how much debt you have, the number of open credit lines in use and your payment history.
Your credit utilization — the amount of your credit limit on revolving accounts compared to what you’re using — should be under 30 percent, and your accounts should be current. Any payment delinquency will make a mortgage loan officer, or any lender, reconsider whether to offer you a loan.
If you have a polished credit score, banks and other financial institutions will likely consider you less risky as a borrower. Focusing on your credit score could require lifestyle changes to start chipping away at debt.
Changing your habits may be a huge hurdle, and you may need to cut back on smaller expenses to prioritize debt payment. Since a chunk of your earnings will go toward your debts, you could lose motivation. However, giving up some comforts can decrease your debt and improve your credit score.
Assume you have the following credit card and loan balances:
- Credit card #1: $750 ($1,000 credit limit, 75% credit utilization)
- Credit card #2: $1,500 ($3,000 credit limit, 50% credit utilization)
- Credit card #3: $250 ($2,500 credit limit, 10% credit utilization)
- Auto loan: $25,000
- Student loan: $15,500
Since your credit utilization significantly impacts your credit score, pay down credit cards with high utilization rates. Start by focusing on those with utilization rates over 30 percent. Reducing the utilization of these two will give you the best chance at improving your credit score alongside paying your other bills on time.
Option 4: Use a balanced method
- Key advantages: You can make your debt repayment plan your own. If you have an emergency, you could manage the expense without sacrificing your goal of getting out of debt.
- Key drawbacks: Without a clear strategy, you could lose motivation.
- Best for: People who need more flexibility but can still stay motivated.
Attacking your largest debt may feel like too large of a financial feat. Smaller debts can wait compared to more pressing circumstances, like debts that have fallen into collections. Debts that get you tax deductions for the interest you pay — like a student loan or a home equity loan used to “buy, build or substantially improve” your home — might also fall lower in the order of importance.
What can you do in these scenarios? Take a balanced approach that’s exclusively your own. You can incorporate any of the three debt repayment options in whichever order you desire. For instance, you could eliminate a debt that’s in collections before paying your credit card down, making only minimum payments on your other accounts in the meantime.
Using the same figures above, you could start by paying off credit card #3 since it has the smallest balance. You could also start with the debt with the highest monthly payment or interest and work your way down. Or you could divide any extra money you have each month and apply a little extra to each debt. Ultimately, you have to develop a sustainable strategy so you won’t lose momentum during the payoff process.
Option 5: Consolidate your debt
- Key advantages: You could receive a lower interest rate, simplify your finances and repay your debt faster.
- Key drawbacks: There could be up-front costs, and there is a chance you may not qualify for a lower interest rate.
- Best for: People making multiple monthly payments with high APRs.
You have a few options if you want to consolidate your debt into a single monthly payment. You could transfer your existing credit card balances onto a balance transfer credit card. The top balance transfer credit cards offer between 15 and 21 months of 0 percent APR on balance transfers, giving you ample time to start paying off your debt without paying interest on your transferred balance.
You could also take out a personal loan and use that money to pay off high interest debt. If you can find a personal loan with considerably lower interest rates than what you’re currently paying, you can lower the overall cost of your debts. Use a debt consolidation calculator to figure out how much you could save by taking out a personal loan.
Lastly, you might want to consider consolidating your debts through a home equity loan or home equity line of credit. A home equity calculator can help you determine whether tapping your home’s equity to pay off your debts can save you money. Remember, if you fall behind on your mortgage payments, you risk foreclosure — so think carefully before taking out a second mortgage to pay off other, unsecured debts.
There are several debt payoff methods to choose from, and you could combine any of these strategies to create a plan that keeps you motivated. Just be sure that whatever plan you choose is realistic for you. Put it in writing and commit to staying the course until you reach the finish line.
Also, consider signing up for a Bankrate account to analyze your debt and get custom product recommendations. You may find that there are debt products out there to help you minimize interest costs while on your debt payoff journey.